Earnings Management

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The difference a penny can make.

In “The Numbers Game,” a much publicized 1998 speech by Arthur Levitt, then chairman of the Securities and Exchange Commission, Levitt warned of the intense pressures on companies to meet earnings estimates. “I recently read of one major U.S. company that failed to meet its so-called ‘numbers’ by one penny, and lost six percent of its stock value in one day,” he noted.

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In the go-go nineties, meeting earnings estimates became something of a religion for corporate executives. It’s easy to understand why, too: Many senior managers had their pay tied to share price performance. To avoid taking a beating, some corporate managers simply tarted up their numbers.

How? By employing a series of small bookkeeping changes that adhered to the letter — though not the spirit — of generally accepted accounted principles. Corporate executives proudly called this strategy “earnings management.” Critics called it gaming the system.

The critics were generally right. The dubious use of earnings management enabled some companies to misrepresent the true financial health of their corporations.

The use of cookie-jar reserves was particularly popular. According to a study conducted by Mark Nelson and John Elliott of Cornell University and Robin Tarpley of George Washington University, reserve transactions represented the biggest temptation to tamper. Twenty-five percent of 515 company earnings-management attempts (EMAs) the professors analyzed involved reserving. That was followed by EMAs involving revenue recognition (15 percent) and business-combination transactions (14 percent). (The study was based on interviews with 253 audit partners and managers from what was then one of the Big Five accounting firms.)

Indeed, one of Levitt’s major points — that too many companies were justifying the setting up of reserves against future liabilities by inappropriately claiming one-shot hits against earnings — cropped up in connection with high-profile accounting scandals at WorldCom and Xerox.

At WorldCom, officers and employees cut company line costs with “improper releases from reserve accounts” as part of its overall $9 billion overstatement of income from 1999 through the first quarter of 2002, according to the SEC’s most recent suit against the company.

Then there was Xerox. From 1997 through 2000, the company “pumped up its earnings by nearly $500 million through the release into income of excess or `cushion’ reserves originally established for some other purpose,” the SEC charged. Xerox, the Commission said, committed a worse violation under the rubric of another earnings-management favorite: revenue recognition. The company improperly sped up the recognition of equipment revenue by over $3 billion, according to the commission.

In the end, the SEC extracted a $10 million fine and three years of restated results from Xerox — but no admission of guilt.

Interestingly, observers say that such high- profile SEC investigations seem to be dampening executives’ enthusiasm for over-the-top earnings management. So, too, have various rule changes promulgated by the Financial Accounting Standards Board. In addition, Standard & Poor’s new “core earnings” metric could also make it harder for companies to set up phony reserves.

But what could really spark the demise of earnings management is the recent flight to ultra-conservative bookkeeping by some corporations. Rather than worrying about meeting Wall Street expectations, a fair share of corporate managers now appear more interested in making sure that investors can fully trust their numbers.

In fact, a few companies are getting out of the estimating business altogether. Management at Coca-Cola, for one, recently announced it would no longer provide earnings guidance. If other companies follow suit — and if corporate pay is no longer tied to short-term share-price performance — corporate officers will be free of much of the pressure to artificially inflate their numbers.

Still, the desire to put the best face on financial statements isn’t exactly a new development. And as some observers note, it’s hard to imagine that earnings management won’t come back in force — in some guise — when the next great bull market hits. After all, everybody wants to tell a good story.